Here are my basic points: reports that are truthful are more useful than those that are not; reports based on assumptions and predictions are not as reliable as reports based on observations; mark-to-market reports are based on observations; other methods of accounting are based on assumptions or untimely measures of investments (e.g., cost); ergo, MTM accounting is superior to other forms.

I had suggested to Paul that while mark-to-market made sense for financial reporting purposes, it might be prudent for banking regulators to ignore it in time like these. His take:

As to your bifurcation into regulatory and nonregulatory applications, why would you prefer that regulatory reporting be based on something that we (and the capital markets) know is NOT true? Why would you want to use something like “economic value” (present value of management’s predictions discounted at management’s rate) instead of market value (observed consensus valuation of lots of buyers and sellers with no predictions or assumptions). The consequence of moving away from the truth is a movement toward a public policy of deceptive reporting as a good thing. This policy is doomed to fail.

Which is exactly how we got into this mess — managers were lulled into investing in very risky (volatile) instruments, in part because the accounting did not reveal their riskiness. Going with mark-not-to-market is an endorsement of not holding managers accountable for their decisions and outcomes. Indeed, it’s organized imaginary accounting. No one believes it except the managers, and no one is calling for bad accounting except managers and Congress. Where is the CFAI on this issue? [Editor’s note: They’re here.]

The apparent objection to MTM is that it reveals what management (a) doesn’t want anyone to know, namely that their investments are risky and volatile, and (b) doesn’t want to confront, namely that they didn’t do their homework and ended up believing others who said that mortgage-backed securities are as safe and sound as CDs. They messed up and they don’t want us to know it and they don’t want to have to fix it. They would rather live in an imaginary world where all income streams are placid and constant.

With regard to capital requirements — wow, that’s where the whole problem lies. They are so over-leveraged with short term debt and over-extended with long-term assets that their real equity is incredibly volatile. If we want safe and secure financial institutions (as a matter of public policy), which option makes more sense? A) Report the real volatility, thereby driving managers to take steps to avoid risky investments or to actually mitigate risk through valid hedging strategies; or, B) Present them with accounting rules that hide the volatility and produce results that suggest there is no risk.

I vote for A) every time.

One more time: messing with the accounting to produce artificially smooth and safe results is a public policy based on deception.

And — don’t forget this point: just because the financial statements project an image that everything is smooth and placid and riskless doesn’t mean the capital markets will accept that image. There is no law in the land that can make investors believe and act on manipulated statements, and there is no law in the land that can prevent them from seeking out other information by other means to try to uncover reality. The obvious public policy is to promote full and timely disclosure of that which is known and desired by the markets so that inefficiency and deception are squeezed out. The consequence is less uncertainty, lower risk, and lower capital costs, with higher values for both bonds and stock. Simple economic logic.